Behavioral economics is a fascinating field and one which actuaries should be aware of in their everyday work. It is the study of inherent biases in human decision-making. Many examples of these biases have been cited in connection with the financial crisis, and increasingly the implications for insurance are being examined. In a speech entitled ‘The Human Face of Regulation’ in April 2013, Martin Wheatley, chief executive of the Financial Conduct Authority (FCA), explained how the FCA is going to use the principles of behavioral economics in the protection of the consumer (see www.fca.org.uk/news/speeches/human-face-of-regulation).

The Courts Act of 2003 fundamentally changed the way that catastrophic injury claims are settled by insurers. It gave the courts the power to enforce a periodic payment order (PPO) as compensation instead of an upfront lump sum payment.

A PPO is an annuity payment from the insurer to the claimant, and is designed to cover ongoing care costs, loss of earnings and other expenses associated with the injuries sustained for the rest of the claimant’s lifetime.

There could be a link between PPOs and behavioral economics. The final claim amount awarded in either a lump sum or PPO case is based on a series of “choices.” These are made by the claimant and/or their representative and the insurer (or, in court cases, a judge). Courts have the right to impose a PPO, but there is still an element of choice as to the amount that is eventually agreed between the interested parties.

Taking a Gamble

A ‘choice’ between a lump sum and a PPO for the claimant is effectively a choice between two gambles. The lump sum gamble is that the amount of money received now may be insufficient to meet future care needs. The PPO should provide more certainty around the ability to meet future needs. However, there are still inflation risks associated with PPOs, and also the consideration that if the claimant dies sooner than expected, the claimant’s estate would have been better off with a lump sum settlement. Could there also be a well-established bias at play here, that of delayed reward discounting (DRD)?

DRD refers to the fact that, in general, humans prefer money now rather than later, and will accept a discount in an immediate amount rather than wait for a larger amount later in time. A quick internet search for DRD will elicit many scholarly examples of experiments demonstrating this effect in both humans and animals. Human experiments focus on small amounts of money (a few dollars), small time delays (days) and do not feature annuity-type choices. Therefore, they are not directly applicable to a choice between a lump sum and a PPO, which involve larger sums and lifetime durations.

One method for pricing excess of loss reinsurance in the presence of PPOs is to convert any PPO claims to an equivalent net present value (NPV) lump sum using the prevailing Ogden discount rate. These converted claims are then used in a traditional lump sum frequency and severity analysis before loading the resultant pricing for the presence of PPOs.

This article was originally published in The Actuary Jan/Feb 2014 edition, and is reprinted here with permission from “The Actuary.”